The quick answer
Start with the owner, not the tax rate.
For most owner-managed operating companies, the conversation should begin with a practical question:
How much money do you need from the business to support your personal life?
Once we know that number, we can build a compensation plan around it.
In many cases, I prefer establishing a regular wage that meets most or all of the owner’s personal cash requirements. This creates a predictable payment schedule, allows income tax and CPP to be remitted throughout the year, and gives the owner a clearer idea of what their personal tax position will look like.
In simple terms, wages are generally proactive. We decide how much the owner needs, establish payroll, and deal with the tax consequences as the money is paid.
Dividends are often reactive, particularly in operating companies. During the year, owners may withdraw money for personal expenses without formally identifying each payment as wages or dividends. At year-end, we then need to review those withdrawals and determine how they should be recorded. A dividend may be used to clear some or all of the resulting shareholder loan balance.
That does not mean dividends are only a year-end cleanup tool. They can also be a deliberate and useful part of a compensation plan. The important point is that the decision should be made intentionally rather than discovered while preparing the year-end financial statements.
Wages and dividends at a glance
Wages
Advantages
- Provide regular and predictable personal cash flow
- Allow personal income tax to be paid through payroll remittances
- Reduce the corporation’s taxable income
- Create RRSP contribution room
- Generate CPP pensionable earnings
- Provide a consistent income record for mortgages and other financing
- Reduce the likelihood of an unexpected personal tax bill
Disadvantages
- Require both employee and employer CPP contributions
- Create payroll administration and remittance obligations
- Are less flexible once the payroll schedule has been established
- Can result in penalties or interest if payroll remittances are missed
Dividends
Advantages
- Do not require CPP contributions
- Usually involve less ongoing payroll administration
- Provide flexibility when the owner’s withdrawals or the company’s profits vary
- Can supplement a regular wage when additional funds are required
- May be appropriate when RRSP room or additional CPP participation is not a priority
Disadvantages
- Do not reduce the corporation’s taxable income
- Do not create RRSP contribution room or CPP pensionable earnings
- Usually have no personal income tax withheld when paid
- Can lead to a significant personal tax balance or instalment requirements
- Must be properly declared, documented and reported
- May be limited by the corporation’s legal and tax circumstances
For many business owners, the best answer is not exclusively wages or exclusively dividends. A planned wage can cover regular personal cash requirements, while dividends can provide additional flexibility when the company’s results and available cash support them.
How wages work
When your corporation pays you a salary or bonus, the amount is generally deductible when calculating the corporation’s taxable income, provided the compensation is reasonable and the applicable tax requirements are met. The salary is then reported as employment income on your personal tax return.
Salary normally requires the corporation to:
- Calculate and withhold income tax and Canada Pension Plan contributions
- Pay the employer’s share of CPP
- Remit payroll deductions to the Canada Revenue Agency
- Prepare a T4 slip after the end of the calendar year
Employment insurance may or may not apply to an owner-manager, depending on the individual’s relationship with and control of the corporation.
The main additional cost is CPP. Both the employee and the corporation generally make contributions on pensionable wages, up to the applicable annual maximums. For an owner-manager, this can feel like paying both sides of the same bill because, economically, that is largely what is happening.
CPP should not automatically be viewed as wasted money. Contributions can increase the owner’s future CPP retirement benefit. Whether that represents good value depends on age, previous contributions, retirement plans and personal preferences.
How dividends work
A dividend is a distribution to a shareholder based on share ownership. Unlike wages, dividends are not compensation for services performed and the corporation does not receive a tax deduction for paying them.
The shareholder reports the dividend on their personal tax return and may claim a dividend tax credit. Canada’s tax system uses the dividend gross-up and tax credit mechanism to recognize that corporate tax has already been paid on the income.
Dividends may be classified as eligible or other than eligible. The classification depends on the corporation’s tax position and can materially affect the shareholder’s personal tax.
Dividends must be properly declared, documented and reported on a T5 slip. Moving money from the corporate bank account to a personal bank account does not, by itself, make the payment a properly documented dividend.
Is one option more tax-efficient?
Canada’s tax system is designed around a concept called integration. Broadly speaking, the combined corporate and personal tax on income paid as a dividend is intended to be reasonably close to the tax that would have applied if the income had been earned personally.
In practice, integration is not perfect. The result varies based on:
- The province in which the shareholder lives
- The corporation’s tax rate
- Whether the dividend is eligible or other than eligible
- The shareholder’s other income, deductions and tax credits
- CPP contributions and future benefit objectives
- Income-tested benefits
- The timing of the payment
Choosing the option with the lowest immediate personal tax does not always produce the best overall result.
Why the decision needs to be made before year-end
Waiting until the corporate tax return is prepared may leave fewer options. By then:
- The calendar year for reporting wages and dividends may already be closed
- Payroll remittance deadlines may have passed
- A dividend may not have been properly declared in the intended year
- The opportunity to manage personal taxable income may have been lost
- Cash may have been withdrawn without clearly documenting how it should be recorded
A bonus may sometimes be accrued at the corporation’s year-end and paid afterward. However, employee remuneration generally must be paid within 180 days after the corporate year-end to remain deductible in that year. Payroll and personal reporting consequences must also be considered.
For corporations with a year-end other than December 31, both the corporate year-end and the calendar year need attention. Corporate deductions follow the corporation’s taxation year, while T4 and T5 reporting follows the calendar year.
December 31 remains stubbornly unwilling to move simply because everyone became busy in November.
What should be reviewed before deciding?
- The corporation’s estimated income and available cash
- The owner’s personal cash requirements
- Other personal income, deductions and tax credits
- Existing RRSP room and future retirement savings goals
- The owner’s age and CPP contribution history
- Whether personal tax instalments are already required
- The corporation’s retained earnings and capacity to pay dividends
- Whether eligible dividends can be paid
- Any shareholder loan balances
- Expected major purchases or financing applications
- Whether income-tested benefits or credits could be affected
- Whether payments to family members could be affected by the tax on split income rules
The bottom line
A good compensation plan should work for both the business and the owner.
The decision between wages and dividends is not simply about comparing two personal tax rates. It involves the corporation, the shareholder and the owner’s longer-term financial goals.
Reviewing the options before year-end gives you time to estimate the combined tax cost, manage CPP and RRSP objectives, properly document payments and avoid unexpected personal tax balances. More importantly, it turns owner compensation into a plan rather than a year-end cleanup exercise.